Sunday, October 15, 2017

Rational Investing is not What You Think - Weekly Blog Post # 493



 Introduction

The recent press accounts of Richard Thaler winning the Nobel Prize for Economics are ironic as to the outlook of the general media, politicians, and many academics. The New York Times headline was “Nobel Goes to Expert in Irrational Behavior.” The truth is irrational behavior is in the eyes of the beholder, not the individual performing the supposed irrationality.

All of my investment life I have been puzzled by how often some very intelligent people have consistently made bad investment decisions (and probably political ones as well).  The classic sign of poor judgment is people being on the wrong side of market tops and bottoms. The definition of market tops and bottoms are when the markets are massively out of balance, with insistent buying or selling pressure.

For years I have been asking the very learned professors at Caltech involved with Neuroeconomics why people make bad decisions. It appears that there is a portion of our brain where we make our judgments, and it is closely linked with our memory. In most cases our decisions are aided or driven by past experiences that produced good or bad results for us. I suggest that this the way humans and animals make decisions. Thus for us individually that is the rational way forward.

Benefitting From Others’ Irrational Behavior

One day sitting in the second semester Economics class at Columbia University, I contrasted the young assistant or associate professor conducting the class with the first semester’s professor, C. Lowell Harris,  a full professor and a consultant to Standard Oil. Harris was a Conservative thinker and was our first teacher of the murky science of Economics. On this particular day, I leaned over to my neighbor and said I wouldn’t trust the second semester teacher to run a newsstand. The new instructor’s pitch was equilibrium pricing, his argument was achieved with the aid of  an “X” marked diagram of where supply and demand met. In the real world, I concluded that different customers were willing to pay different prices at different times and conditions for the same product or service. I was proud of my analysis.

I was very wrong and it took me a number of years to find the real value of the experience. The study of economics began with the study of philosophy, but actually had major lessons that could have been drawn from the Bible.  Academic economists had in effect “Physics Envy” with their mathematical equations and reproducible laws. Thus many texts teaching economics became loaded with laws that worked some of the time and equations which collapsed when applied to reality. To them and their students, humans were meant to solve economic and investment problems with the use of equations if they were to be considered rational.

In the standard liberal arts education there was often a requirement to take a course in economics and this was particularly true if one was concentrating on political science, These requirements led to at least two generations of students expressing themselves in adult behavior believing in top-down thinking and that people would make decisions using formulas.

The recent Brexit elections and the 2016 US Presidential election and possibly the Austrian election are samples of voters not voting in favor of their current economics, but based on their feelings for change.

In an interview in this week’s Barron’s, one of the more financially successful Professors of Economics, Robert Shiller, sees the need for narrative economics. I agree. One example of the need to capture the critical elements of a change in direction is the study of the 1987 one day decline of 22.6% in the Dow Jones Industrial Average, the biggest one day decline in DJIA history. Very few of the reports on the day revealed that the Chicago’s future market did not have an uptick rule for futures to be shorted and that the New York Stock Exchange did. It was in the Chicago market that the automatic, non-price sensitive futures were executed as part of the portfolio insurance programs. Thus at the opening, the NYSE could not short to absorb the Chicago selling. This is an example of regulatory arbitrage, some of which exists today.


Rational Worries

We all know that there will be major stock and bond market declines in the future, perhaps coordinated with economic recessions/depressions. What I don’t know is when, how deep, and the proximate causes. Since I don’t know these, the best I can do rationally is to look at conditions that have led up to other major disruptions. My Blog Post 488, Seven Steps to the Big One outlined my concerns. If you would like a copy, email me at Mikelipper@gmail.com.

 

On my watch list is the battle between creeping enthusiasm and complacency as noted below:


  • ETF/ETN markets dominated by trading entities, particularly in sector and countries.
  •   Short interest declining on major exchanges.
  •   China’s successful managing of the internal debt structure, can it last?
  •   There is no recognition that at some point the US dollar will decline vs. others.

A Rational Move I Have Not Made Yet

I am assuming that when we experience the next major decline it will be largely cyclical and most investments will survive and endure the inevitably poorly-written new regulations. Looking beyond that point for the eventual benefit of younger beneficiaries, I am considering secular investments that will pay off in twenty or more years.

During that time we will have three key trends:
  •  The population will grow particularly in Africa and South East Asia. The rest of the world will get older and some sicker.
  •   The amount of farming land will shrink.
  •   The price and quality of our food will rise.

On the basis of these trends I am looking for investments in the agricultural commodities arena. There are a number of funds in this classification who have an average year-to-date performance of minus 7.12%. At this point I have not done the work to select funds. What I have done, some time ago, is to buy Man Group plc. This is not a recommendation as I don’t know enough, but it is the largest distributor of trend-following commodity funds, and could be of interest to our professional audience.

Two questions of the week:

1.  What are you watching for a top, and are you planning to do anything?
2.  Do you have any knowledge on investing in farms and/or commodities?  
__________
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A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.

Sunday, October 8, 2017

Our Biggest Risk: Change - Weekly Blog # 492



Introduction

The proper function of active portfolio management is to be aware of possible forthcoming change and to anticipate its arrival.  It is this very function that we are least prepared to accomplish well and therefore the biggest single risk that we and our investors share. They at least have the benefit of being able to blame their professional managers, but since they selected the managers this is self-deception.

Why are we so unprepared to anticipate and take some advantage of future changes? In an over-simplification, the description is the differences between Art and Science. There is a great amount of art in what scientists do, and artists utilize science, often well. The difference in its simplest form is the scientist starts with existing formulas and focuses on what is there. Some artists focus on what is not apparent and perhaps what in their mind should be.

In the portfolio management world the scientists are guided by specific or at least implied facts that have repeated themselves enough so that they become rules, laws, or the current term - factors. All of these are a product of a mental prison. The prison can be labeled EXPERIENCE. If the timing of these “portfolio scientists” is propitious they may make relatively small gains.

The gigantic gains in terms of rewards or avoidance of pains comes from sensing what is not readily seen by most at the time. In the recent two weeks I became focused on long-dead geniuses. The first was the Nobel Prize for the efforts led by professors and laboratories of the Jet Propulsion Lab that Caltech manages in proving Albert Einstein’s 100 year old theory as to the impacts of gravitational waves in space. (This achievement only took over 1000 people and over $ 1 Billion NASA dollars and a strong contrarian view.) Nevertheless within a few weeks after the beginning of its operations, they were able to detect a number of collisions of black holes that release a huge amount of measurable energy.

Last night my wife Ruth and I enjoyed a magnificent musical performance conducted by the incomparable Xian Zhang and the New Jersey Symphony Orchestra playing Beethoven’s Emperor Concerto for Piano and Orchestra. Beethoven is another example of a genius well ahead of his times. What I didn’t  know was when Beethoven composed this piece in 1809 he anticipated the development of the modern piano different from the one of his day. It would take a half century before the present day piano arrived.

Today we are the beneficiaries of these geniuses’ work; one and two hundred years ago they saw what was not  seen by the rest of their professional colleagues. Perhaps for us in the portfolio management business the lesson is avoiding some of the penalties from using outdated instruments and thinking.

I have been concerned as to how to prepare for future changes and how they will impact future generations of beneficiaries of the art of portfolio management.

Future Political Changes

In last week’s blog I alluded to both the French and Russian Revolutions and that the early leaders of dramatic changes were replaced by more radical leaders who appeared to be able to more quickly accomplish structural changes that were promised. Today on every continent we have leaders who have sold themselves to the voters and other decision-makers as change agents that are being bogged down with the lack of sufficient political power to accomplish their promised goals. At some point, if the inability to make major structural changes continues, the present crop of change agents will be replaced either through the voting box or more violent means either from the Right or the Left. My fear is that due to technology and global economics we could enter a post-national world that may look like City/States with defense, military, and economic alliances. In such a world, the force of law on contracts may be quite different than what we are enjoying today. 

I don’t know whether the changes will be good or bad or more likely both. Neither do I know who will be the winners and losers. What it does suggest is that it may be prudent to be widely diversified not only in terms of geographies, but economies, and perhaps most importantly, the rule of law and taxation.

Financial Structure Possible Changes

Most of the readers of this blog and I are much more focused on equity investing than fixed income investing. The historic reason is that stocks are where we can profit the most. We tend to forget about the bond market. This is a mistake for three reasons:

1.  The bond market is bigger than the stock market around the world.

2.   Equities are leveraged directly or indirectly by the borrowings of governments, businesses, and individuals.

3.   The basic contractual laws were developed to establish “fair dealing” between lenders and borrowers which is also the basis for rules for equity owners.

Today, the size of unfounded  and contingent obligations question to the lenders that each and every future dollar or equivalent will be paid on a timely basis without significant increases in taxes and other transfers.

One of the tenets of being a contrarian investor is to get increasingly concerned about one sided markets. In many countries, (including the US) there has been more money going into bond funds than stock funds. These funds and many retirement funds are buying bonds pushing their prices up and yields down. Historically the differences in yields were an indicator of perceived risk. What are the financial markets saying when the yield on US Treasuries are 2.3% which is the same yield as the market is placing on emerging market stocks? Now the best thing that can happen to the owner of Treasury paper is to get paid the maturity value upon its liquidation, nothing higher. Over the next ten years the dividends on Emerging Market stocks can rise or fall. Clearly the Emerging Markets have trade, product, and currency risks that the Treasury paper does not. The equity market appears to be much more discriminating as shown in the yield table of equity indices below:

Below 2%
2-3%
3-4%
Above 4%
India
Japan
France
Australia
S. Korea
Mexico
Italy
Russia
China
Germany
Sweden

US
Brazil
United Kingdom


Canada
Spain


South Africa



Each list starts with the lowest yield, the most favored country in the yield range.

The stock markets appear to make significant distinctions that bond aggregates do not. There are some skilled bond investors working in the emerging market space. One that came to my attention this week has top three holdings in Kenya, Senegal, and Iraq. For lots of political, social, and religious reasons some investors might object to investing in these or other countries, their withdrawal as potential investors could reduce the number of buyers and make higher yields available to other investors.

As a contrarian I expect the flow of money into bond funds will be at best counterproductive,  if not producing meaningful losses. I am also concerned that the brokers and advisors who put investors into bond funds will lose face and clients for  their actions. Much of the flow into these funds comes from large broker dealers and large registered investment advisors. As much of the flows have gone into fund companies that also offer stock funds, hopefully the fund houses will be able to convert a significant portion of the residual bond investments into stock funds to preserve wealth and give the investors a chance to recover some of the expected losses. If this exchange happens now the scenario may work. There is a dreadful chance that the switch will happen concurrent with an eventual top of the equity market.

Equity Market Structural Risks

The European Union in January will put into effect rules that will have the effect of reducing payments for brokerage delivered research that may impact institutional trading around the world. From an investor standpoint this will likely remove the research support for many smaller companies which will lower their potential market value. This is occurring at the same time that in the US for various administrative rules and tax implications, the number of publicly traded stocks has been cut in half from the number of publicly traded stocks of years ago. It is much too early to tell whether the currently discussed tax bill and the desire of the Administration to reduce the burden of regulation will have a positive effect on stock prices. It would not be the first time that the unintended consequence of changes has the opposite impact to the government’s desires.

Investment Policy Considerations

As we may have entered a world where the historic factor type of rules based management may produce competitive results, it could be the time to drastically increase diversification. This is not just adding to the number of securities in the portfolio. It means having an increase in the number of themes used in the portfolios. It could well mean to begin a position in some of the currently worst performing segments such as agricultural commodities. It may mean to invest in local securities around the world. For us who manage portfolios of funds we may need to add new managers who think differently than some of our very successful present managers.

Bottom Line

We may have entered a period of structural changes that we need to recognize and begin to take actions to protect the assets of future generations.

Question to Dwell on: Can you evolve your thinking ahead of the headlines?    
__________
Did you miss my blog last week?  Click here to read.

Did someone forward you this blog?  To receive Mike Lipper’s Blog each Monday morning, please subscribe using the email or RSS feed buttons in the left margin of Mikelipper.Blogspot.com

Copyright ©  2008 - 2017

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.